Banks Bounce as Spreads Widen

January 5, 2022

From the desk of Steven Strazza @Sstrazza and Ian Culley @IanCulley

Downside pressure on long-duration rates and a flattening yield curve was the story of the bond market for the latter part of 2021.

But we started to see signs that downside risks were easing in the final weeks of December. The 10- and 30-year yields made a nice kick save after undercutting their summer lows, and high yield bonds $HYG began to outperform safer alternatives like the Treasury bond ETF $IEI.

It seemed like the bond market was heading in the right direction – except for Treasury spreads. The 2s/10s spread was the missing piece of the puzzle, continuing to push toward new 52-week lows…

Until now!

Only a couple of trading sessions into the new year, the bond market is providing plenty of fireworks. Rates are jumping higher across the curve, and critical treasury spreads such as 2s/10s, are following higher:

Whether or not the 2s/10s would dig in and begin to widen was a significant concern given its impact on cyclical assets and value stocks – especially financials.

We’ve pointed out in earlier posts that when these spreads are widening, the difference between what banks collect from their debtors versus the interest they pay out for cash deposits increases. Basically, they make more money.

Now that we’re seeing the 2s/10s and 3mos/10s expand, it bodes well for the bottom line of many financial institutions.

And bank stocks seem to like it!

It’s no wonder banks of all sizes broke out yesterday – big banks $KBE, regional banks $KRE, and community banks $QABA:

All have reclaimed their first-half highs from 2021, which is supportive of the recent rally in rates.

Financials taking out these former highs and getting in sync with the bond market is a huge development. It’s not only constructive for financial institutions; it’s also bullish for risk assets in general.

Think materials, commodities, energy, and other long-forgotten cyclical corners of the market. These pockets are poised to benefit most from an inflationary backdrop that supports global growth.

With rates on the rise across the curve, key treasury spreads widening, and the financial sector showing strength, it appears the reflation trade is getting back in gear.

The US 10-year yield is currently trading at its highest level since April. With our bond market ratios, like high yield versus Treasuries and stocks versus bonds, breaking back above their first-half highs, we think it’s only a matter of time until the 10-year follows.

Now that treasury spreads appear to have bottomed and banks are finally participating, everything's coming together in the bond market.

And it’s all suggesting higher prices for risk assets.

Countdown to FOMC

Following Wednesday's release of the minutes from the Federal Open Market Committee's most recent meeting, the market is now pricing in a rate hike in March 2022.

Here are some of the probabilities for the March meeting based on fed funds futures: